Rather than focusing on CECL compliance alone and getting little or no return on their investments, credit unions can generate incremental value by using that investment to improve their processes and models.
The 2019/2020 deadline for implementation of the Financial Accounting Standards Board current expected credit loss standard will be here before we know it. The investment that will be required to comply with the new rule—some estimates put it at $1 billion industrywide—is creating a stir. Fortunately, credit unions can leverage these investments into their overall credit risk management efforts.
In other words, the opportunity presented by CECL implementation is to go beyond compliance with the FASB accounting rules to enhance (and even validate) a CU’s credit risk management practices. This is doable if the CU focuses on the potential benefits and not just “another regulatory burden.”
Regarding implementation, keep in mind that CUs’ estimation of credit losses will not be precise out of the gate. The majority don’t have sufficient data and/or history in their portfolios (at least five years can be good, depending on the loans in the portfolio) to create precise models with statistical validity. Proceeding on the basis of that reality check, CUs are better off focusing on the process to better estimate losses than trying to achieve absolute precision at implementation—because that preciseness will ultimately be wrong.
The basis for any implementation of CECL is the use of the formula:
Expected Exposure/Balance x Probability of Default x Loss Given Event of Default
Putting a process in place that continues to refine and improve estimates in this formula will not only check off that FASB compliance box, but actually help a CU better understand its credit risk profile.
For consumer/mortgage credit, most CUs have credit models and scorecards to estimate losses. The key to these models is recognizing that a member’s credit profile changes. If the changes are not tracked, they could expose the CU to unnecessary risks. Tracking these changes is a best practice called credit migration monitoring. While a CU may not originate a sub-prime loan, it may find itself with a sub-prime loan in its portfolio three years later should the individual credit profile deteriorate. CECL’s requirements can help some CUs be more efficient and effective in their credit migration monitoring while helping others put in place a strong business practice.
While the CU will capture the score and estimated loss at the time of origination, refreshing the estimate on the entire portfolio on a regular basis provides a better and more up-to-date estimated probability of default.
Updating the score allows the consumer/mortgage lending group to monitor portfolio trends. More importantly, it can help identify specific borrower deterioration or identify borrowers who may represent a great cross-sell opportunity.
Commercial credit offers a similar opportunity to refine how credit risk is managed today. Too often, a credit union finds itself with a large concentration of its commercial portfolio in a single risk rating. For example, a credit union may have a rating scheme of 1 to 9 but most of the credits are rated 6. Consequently, the credit union will find itself with a single probability of default even though the underlying portfolio is more diverse. When used in the loss estimation formula, this will likely result in an estimate of loss that’s too big or too small.
As a result, it is critical to ensure that the risk-rating model represents the underlying distribution of the portfolio across the risk ratings. This will help the credit union progress in its modeling capabilities without getting into minutia. Remember, the goal is to achieve an educated starting point rather than absolute precision at implementation.
Without a doubt, credit unions will spend money on CECL (e.g., new reporting, databases, people). But rather than focusing on compliance alone and getting little or no return on their investments, they can generate incremental value by using that investment to improve their processes and models.
Vincent Hui is a senior director with CUES Supplier member and strategic provider for ERM and technology services Cornerstone Advisors, Scottsdale, Ariz. Hui thanks Cornerstone’s Steve Carroll, Joel Pruis and Todd Stringer for their contributions to this article. Carroll is director/business continuity, Pruis a senior director and Stringer director of IS services.